Commentary on Economics, Information and Human Action

Cost savings and value creation are different

The cost saving-focused mindset has prevailed in regulated industries for over a century, slowing innovation in the process. In electricity, regulation that bases firms’ profits on cost recovery erects market barriers by recognizing only a business model that involves providing a specified product (110v power to the home) transported over a monopoly network. Even in 2011, well into the third decade of the digital revolution, this narrow focus and cost-saving mindset persists, and it fetters smart grid-enabled economic growth by emphasizing cost recovery and ignoring value creation.

In fact, one of the main reasons why smart grid investments face regulatory and political opposition is that focus on cost recovery (among others). I think this Greentech Media article gets the story right: the ways that smart grid investments can lead to cost savings are limited. We’ve discussed this idea here at KP quite a bit — a limitation on the benefits of transactive technologies and dynamic pricing is the fact that for most people, electricity bills are not a large share of their annual expenses, so even saving 15% on the electricity bill may not be a salient enough benefit to induce a lot of people to make technology investments. In other words, smart grid may or may not lead to cost savings for a lot of residential customers.

But is that the right metric by which to evaluate smart grid investments? Of course not. The Greentech Media article linked above starts with a telecom metaphor that I use frequently. In nominal terms, most of us pay much more for our communication services today than we did when all we had was a single land line (and leased Western Electric phone!) back in the 1980s, and even in real terms we probably still pay more than we did then. But look at how much more value we get — mobility, Internet, automation, all of the services that have been created at the edge of the network. We are much richer and better off because of the change in communication technologies and services since the 1980s, even taking into account that we pay more for them. Apply this metaphor to the regulatory calculus today, and the mismatch of its cost recovery focus and the benefits arising from new value creation is apparent. Innovation in telecommunications didn’t occur and thrive and expand because of cost savings and cost recovery, but instead because of new value creation.

Those who argue that the business model for customer-facing smart grid investments has to be grounded only in cost savings are incorrect, and are looking too narrowly at consumer value propositions. This debate came up in the post I wrote in October about the new Nest thermostat, a gorgeous and beautifully designed piece of consumer-focused in-home technology from a group of former Apple engineers, and in other articles about Nest around the same time. Observers from this traditional cost savings mindset dismissed the Nest thermostat because of its $250 price tag, saying that consumers would not save enough money to make the payback period on it make sense, even with dynamic pricing. This criticism overlooks the additional features and capabilities of such a device — motion sensing, serving as a hub to integrate and manage and automate in-home digital devices, learning algorithms, extensibility to be able to bundle with other digital services in the home, and so on. It also overlooks the persistent pattern in the history of new technology adoption, from the Roman baths onward; there will always be consumers with strong “first adopter” preferences, who are willing to pay more to be the first ones to have the novelty, and in the case of digital devices, incur that cost fully aware that prices will fall in the future as the technology matures. They guinea pig new technologies for the rest of us.

Those two aspects — additional features and first adopter preferences — mean that a lot of the value proposition in consumer-facing smart grid technologies is new value creation, not cost savings. This means that the regulatory calculus and the traditional electricity cost-focused mindset misses the real action, the real opportunity, the real potential that the investments could unleash.